Multiple-Round Strategy

Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts

McCarter & English LLP


Few, if any, start-ups survive to maturity on the basis of a single round of financing. It is in the nature of the venture-capital beast that companies consume cash in their early stages at unforeseen, sometimes alarming rates. Not only must products be developed, but in the classic venture-capital scenario, a new market must be penetrated and sometimes created. Digital computers, xerography, express mail, the Internet—these were not products developed to satisfy the public perception of existing demand. Rather, the existence of the product created—uncovered, if one prefers—the demand; necessity was not the mother of invention. Today it is difficult to see how humanity could get along without these staples. Nonetheless, no customers' queue awaited computers until the computer was introduced and created the queue in the first instance.

Accordingly, the need of a start-up for frequent and regular infusions of cash is an imperative of the business, part of the culture of venture-backed startups. A sensible financing strategy focuses not only on the round on the table, but on the impact of subsequent rounds as well. Ultimate dilution of the founder will depend on the success or failure of the company in raising subsequent rounds at higher prices. In considering a given investor's offer, the founder must make a judgment whether the investor has the staying power to support the investment in subsequent periods and will do so at a fair price. Leasing money, in other words, is a longitudinal process; it extends at least until the exit strategy is implemented.

If there is one single enemy encountered by a founder in a venture financing, it is investor indecision and delay. Founders contribute to the problem because they listen selectively, interpreting a politely worded "no" as an invitation to continue with the presentation. To induce investors to declare themselves, one strategy is to line up a lead or "bell cow" investor and hold a first closing, escrowing the proceeds of the offering until enough subscriptions are collected to round out a viable financing. The hope is to create some form of stampede among investors on the fence. At the least, an early closing will serve to freeze the terms and diminish niggling over minor points.

The first round is usually the most dilutive financing, because, obviously, it occurs at the moment of highest risk. Therefore, an intelligent founder will attempt to strike a balance in his first round between obtaining as much money as he thinks he'll need to get to the next stage of development, but not so much that his equity is reduced to the borderline of triviality.

If it is assumed that later rounds will be less dilutive, then it is obvious that the first round should raise the smallest amount of money necessary to take the enterprise to the next round. On the other hand, if money is available, it could be a gross error of judgment not to take it, since the second round may (as it often is) be a good deal more difficult than anticipated, perhaps only because fashions change.

One old saw has it that a startup firm never has enough money, and there are anecdotes in sufficient number to illustrate that proposition. There is, however, contrary evidence, not only to the effect that the first round can be unnecessarily dilutive but that some companies are cursed in their early stages with too much money. For example, a dynamic manager may break away from a company he's helped found and start the process all over again. Since venture investors are no less sheeplike than the rest of us, they extrapolate the past and assume that Mr. Genius can do it again. The founder takes a pregnant idea and money falls in his lap. He's not worried about dilution in the first round because of the valuation he has been able to sell to the investment community. Forgetting the parsimonious habits of his youth, the founder then attempts to shorten the development process by doubling the number of sales and marketing people, putting on more technicians and so forth. He creates a monthly expense outlay, a "burn rate," which is out of proportion to realistic expectations of the company's development. When it comes time for a second round, the existence of a massive burn rate has inexorably postponed the date on when cash break-even will occur by a period which intimidates old and new investors. Only those who have gone through the process know how difficult it is, both logistically and in human terms, to make dramatic slashes in a burn rate. Unsympathetic landlords may refuse to take back the necessary space; firing people imposes separation costs as well as personal trauma.

In short, a higher-than-necessary burn rate is a bad sign, a red flag to the venture-capital community. Founders consistently complain the investors are starving them. Fed hand to mouth, they bemoan the opportunities missed for lack of capital; they cite the fact that venture capital is an early-entry strategy. As General Nathan Bedford Forest said, "Get there fastest with the mostest." True in some instances, but the converse is equally likely, based on evidence of the past: Too much money equals potential trouble.


Introduction to Venture Capital and Private Equity Finance